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You Don't Necessarily Need Sales Growth to Grow Profits but be Wary

DuPont and Dow each achieved strong earnings growth last year, but analyzing their underlying performance reveals a concerning trend.

Investors suddenly seem concerned about the state of corporate profits. Actions taken by the Federal Reserve have set a fire in the market's belly. Add that to the sudden concerns over economic growth in the emerging markets, and it's not entirely a surprise why the Dow Jones Industrial Average and S&P 500 Index have sold off over the past couple of weeks.

At the same time, major chemicals companies including Dow Chemical (NYSE:DOW) and DuPont (NYSE:DD) have had almost nothing but great things to say in their most recent earnings reports. They're rising above the broad macroeconomic concerns and reporting strong profit growth. In case you may be asking yourself how this is possible, here's how they're able to do it.

Self-help is the key to growing profitsChemicals producers Dow and DuPont are mostly achieving earnings growth through internal measures such as aggressive cost cuts, as well as share repurchases. These are helping to boost the bottom line through reduced expenses as well as resulting in fewer shares to divide profits among.

Actions such as cost cuts and share buybacks are boosting profits much more so than revenue growth, which should be a pivotal focus point for investors going forward. That's because cost cuts can only go so far to keep profits grinding higher. At some point strong revenue growth, the lifeblood of any business, needs to kick in.

Consider that Dow nearly doubled its adjusted earnings in the fourth quarter, and grew adjusted earnings by 31% in 2013. Meanwhile, DuPont's core operating profits jumped 52% in the fourth quarter, and rose 17% to $3.04 per share last year.

While their profit figures are impressive, their revenue growth isn't keeping up nearly to the same degree. It's worth noting that Dow and DuPont posted just 3% revenue growth each in 2013. It's clear that profit growth is being achieved largely through cost savings.

For example, Dow delivered more than $500 million in cost reductions along with another $850 million in proceeds from divestitures. DuPont increased margins through 5% higher volumes, but it also reaped considerable gains from its productivity initiatives.

Seed giant Monsanto (NYSE:MON) did a much better job of producing organic revenue growth in fiscal 2013. It grew sales by 10%, as it's clearly benefiting from the boom in global food demands. A longer-term view paints an even brighter picture: Monsanto's revenue is up 26% since fiscal 2011. The agriculture industry has a strong underlying tailwind, since rising worldwide populations place an unprecedented strain on food production.

Watch where the money goesIt's clear from how Dow's and DuPont's management teams are setting the stage for the upcoming year that neither company is expecting economic growth to accelerate in 2014. Instead of reinvesting significant portions of last year's profits into strategic growth initiatives, Dow and DuPont are simply funneling cash back to shareholders. This will be achieved by even greater share buybacks, as well as increased dividends.

Dow is sending money out to shareholders hand over fist. First, the company just increased its cash dividend by 15%. In addition, Dow added $3 billion to its existing share repurchase authorization, to a total of $4.5 billion, to be completed by the end of the year. For its part, DuPont declared a brand-new $5 billion share repurchase program, which replaces its existing buyback program. Of the $5 billion, the company expects to utilize $2 billion in the upcoming year.

Keep revenue in mind going forward

DuPont and Dow did a great job improving their bottom lines last year. In such an uncertain economic climate, it seems foolish to try to find fault with companies that are growing profits so strongly. However, there's a meaningful difference between profit growth obtained by cost cuts versus organic revenue growth. Cost reductions can only take a company so far; at some point, DuPont and Dow will have to start growing revenue for their outsized profit growth to continue.

Author

Bob Ciura, MBA, has written for The Motley Fool since 2012. I focus on energy, consumer goods, and technology. I look for growth at a reasonable price, with a particular fondness for market-beating dividend yields.